Inflation
Inflation: Definitions
Agenda
• Definition
π(t) = {[ ( P(t) – P(t-1) ] / P(t-1) } * 100
• Inflation
¾ Definitions
• π is dynamic and, therefore, more
complicated than the P level, which is static.
• The Costs and Benefits of Inflation
• The “Simple” Phillips Curve
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Inflation: Definitions
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Inflation: Definitions
Inflation Rate
Year-on-Year Percent Change
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• Inflation
¾ A sustained rise in the general level of prices.
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• Accelerating Inflation
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¾ A rising inflation rate.
• Disinflation
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¾ A slowing inflation rate.
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1960
1965
1970
1975
1980
1985
1990
1995
2000
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Inflation: Definitions
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Costs of Inflation
• Deflation
• Inflation can be either:
¾ A sustained fall in the general level of prices.
¾ Anticipated or
¾ Unanticipated
• Incorrectly anticipated
• Hyperinflation
¾ An inflation rate of 50% per month or more.
• More than 1% per day.
• 100-fold increase in prices per year.
• 2 million-fold increase in prices over 3 years.
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Costs of Inflation
Costs of Inflation
• Costs of inflation
• Arbitrary Redistribution of Income
¾ from those who do not, or cannot, raise their prices
¾ to those who can, and do, raise their prices
¾ Arbitrary redistribution of income
• Creates winners and losers
• and still sell their goods
¾ Information and Uncertainty costs
• Contracts can prevent price increases
• Reduces information and increases uncertainty
¾ Mortgages and other fixed interest rate contracts
¾ Institutional and Constitutional costs
• Redistribution from lenders to borrowers if inflation rises
• Degrades institutions and conventions
¾ Wage contracts
¾ Shoe-Leather and Menu costs
• Redistribution from employees to businesses if inflation rises
¾ Fixed pensions
• Absorbs resources from productive activities
• Redistribution from retirees to pension plans if inflation rises
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Costs of Inflation
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Costs of Inflation
• Informational and Uncertainty Costs
• Arbitrary Redistribution of Income
¾ Informational costs: relative prices become less
meaningful the faster is inflation
¾ Results from unanticipated inflation
• Or incorrectly anticipated
• Leads to Money Illusion
• Higher inflation reduces the time period for which
price information is valuable
¾ However, this is a zero sum situation
• Winners win exactly what losers lose
• Therefore, not a macroeconomic problem
¾ Uncertainty costs: higher inflation generally
leads to more variable inflation. More variability
leads to less certainty
– Unless there is a substantial international net
creditor/debtor status.
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Costs of Inflation
• Which can reduce economic growth
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Costs of Inflation
• Institutional and Constitutional Costs
• Shoe-Leather and Menu Costs
¾ Very high inflation undermines institutions and
conventions based on relatively fixed prices
¾ Higher inflation increases the cost of doing
business by requiring resources to be devoted to
adjusting to rapid price changes
¾ Reflected in erosion of faith in government, the
economy, and money
• Shoe-leather costs: Resources used by increased
cash management practices
• Menu costs: Costs associated with frequent price
changes
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Costs of Inflation
Benefits of Inflation
• High inflation will reduce long-term growth
• Benefits of inflation
¾ Diverts resources away from production
¾ Distorts and/or delays expenditures by consumers and
businesses
¾ Facilities relative price changes
¾ Money illusion
• Facilitates real wage adjustment
• Because of higher interest rates
• Because of greater uncertainty
¾ Negative real interest rates
¾ Devalues institutions and the use of money
• Important for macroeconomic policy
• Lower inflation may boost long-term growth
¾ Seignorage
¾ This has led to mandates for central bank independence
and exclusive focus on inflation
• Revenue derived from money creation
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Costs of Hyperinflation
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Costs of Deflation
• The real burden of debt rises.
• Generates a self-perpetuating economic
contraction by delaying expenditures by
consumers and businesses.
• Renders monetary policy totally ineffective.
• Arbitrary redistribution of income.
Shoe-leather costs become very serious
Menu costs are substantially higher
Relative price signals are meaningless
Microeconomic inefficiencies skyrocket
Tax distortions become huge
Massive inconvenience
Becomes intolerable
¾ From borrowers to lenders.
• Who have lower mpc’s.
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Inflation and Policy
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Inflation and Policy
• What is an appropriate level for inflation?
• What is an appropriate level for inflation?
¾ High inflation is “undoubtedly bad”
¾ Reducing inflation has costs
• But how high is “high” inflation?
• Reduced output
• Slower growth
• Higher unemployment
¾ Hyperinflation is clearly too high
¾ Deflation is also “undoubtedly bad”
¾ Zero inflation also imposes costs
¾ Low inflation is likely “best”
• But how low is “low” inflation?
• How high is “low” inflation?
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The Phillips Curve
The Phillips Curve
• Observations
¾ When inflation is high, unemployment tends to
be low
¾ When inflation is low, unemployment tends to
be high
• The inverse relationship between inflation
and unemployment is called “the Phillips
Curve”
¾ The core of many models of the economy
• Tells policy makers the conditions for effective
policy, i.e., what the trade-offs are.
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The Phillips Curve
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The Phillips Curve
π
• Position and slope are important
¾ Position identifies the attainable goals
• Points off the curve are not attainable
¾ Slope identifies the trade-off
• Steep curve => big change in inflation for small
change in unemployment
• Flat curve => small change in inflation for big
change in unemployment
Phillips Curve
U
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The Phillips Curve
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The Phillips Curve
π
• Instability of the Phillips Curve
¾ The actual relationship between inflation and
unemployment has been unstable.
∆π
• Hypothetical shape valid only for short time periods
• Shifts generally due to supply shocks
PC
∆π
∆U
∆U
U
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The Phillips Curve
The Phillips Curve
π
• Long-Run and Short-Run Phillips Curves
¾ In the short-run, there may be a trade-off .
• A difficult policy tool because of potential shifts.
• Still one of the most relied on short-term decision
making tools.
¾In the long-run, there is no trade-off.
PC
PC
• The Phillips curve is vertical at the natural rate.
PC
U
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